These two giant mortgage lenders are poster children for the dangers of wrapping government guarantees around the credit markets. With help from the state-sponsored banking system, these two government-sponsored entities (GSEs) perverted the process of credit intermediation and artificially suppressed the cost of mortgage loans over many decades.

This perversion of mortgage finance explains why house prices grew faster than household incomes for roughly a decade ending in 2006. With the broad recognition that the GSEs were insolvent in late 2008, the artificial suppression of mortgage rates was about to come to an end. That is, until the Treasury and Federal Reserve doubled down on their commitments to throw good money after bad. Now, permanent manipulation of mortgage interest rates has become official government policy. The cost of this policy will be even higher federal deficits in the future.

Government guarantees temporarily hide risks, which results in foolish capital allocation throughout the economy. This game can last until the activity collapses under its own weight (like housing in 2007), or until the government itself runs out of financing options at affordable interest rates.

Just like Medicare policies influence the practices of health insurance companies, Fannie and Freddie mortgage-backed security (MBS) guaranty policies influenced the underwriting behavior at mortgage brokers. Therefore, no one should be surprised that mortgage brokers fudged numbers to shoehorn borrowers into "conforming" mortgages. These brokers generated huge profits by unloading massive amounts of underpriced credit risk into the Fannie and Freddie MBS pipeline.

Mortgage expert Mark Hanson described the triumph of automated mortgage underwriting over prudence in a December 2009 issue of the Mortgage Pages:

During the bubble years, the GSEs looked at [debt-to-income ratios] secondarily to credit score, [loan-to-value ratios], and cash reserves as measured by liquid cash and 70% of retirement [assets]... During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.

Many lenders, especially the big banks, had...underwriting "trainers" that would go around to the various mortgage branches and teach underwriters how to "trip" the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of...a borrower with a 100% [debt-to-income ratio] - with limited documentation required on the automated findings - was not uncommon.

The poorer-than-expected quality of the mortgages inside of the MBS that Fannie and Freddie guarantee will lead to hundreds of billions in credit losses. The frequency and severity of these credit losses over the next few years will take Wall Street by surprise.

These credit losses will blow huge holes into the GSEs' balance sheets, overwhelming their thin slices of capital several times over. When this capital vanishes, the US Treasury Department will float more government debt and use the proceeds to refill the capital shortfalls.

On Christmas Eve, the Treasury delivered a lump of coal to US taxpayers: It eliminated caps on future equity injections into Fannie Mae and Freddie Mac. Let's not kid ourselves. These capital injections are not "investments." No rational investor would be injecting equity into the GSEs right now. Rather than demand a reasonable risk-adjusted return, these injections will just keep the GSEs' loss-plagued balance sheets solvent.

Consider the situation by visualizing Fannie's and Freddie's balance sheets. Since the beginning of the financial crisis, the Treasury and Federal Reserve have teamed up to reinflate the assets and equity of these institutions. The Treasury pumped new equity (in the form of preferred stock) into them as needed, while the Fed used newly printed money to buy up the GSEs' debt and the mortgage-backed securities that the GSEs guarantee. Thanks to these shenanigans, the market prices of the assets on the GSE balance sheets appear to be holding up. But make no mistake; despite the Fed's actions, the real underlying value of these is being eaten away by credit losses.

On Jan. 12, Amherst Securities published a study on the estimated losses Fannie and Freddie will absorb as foreclosures flow through the credit loss pipeline in the coming years. Using a database of 29 million active prime mortgages from First American CoreLogic, Amherst estimates that the GSEs will ultimately suffer $448 billion in cumulative credit losses. Amherst explains the likely distribution of these losses:

These gross losses will be distributed across four categories - write- downs already taken by Fannie and Freddie and reflected in their loan loss provisions, future credit losses to be taken by Fannie and Freddie, losses absorbed by mortgage insurers, and losses absorbed by originators through put backs. Fannie's loan loss reserves total $66 billion: $57 billion for MBS guaranty losses, $9 billion for loan losses. Freddie's loan loss reserves total $30 billion: $29 billion for MBS guaranty losses, $1 billion for loan losses. The remaining $352 billion of losses will show up across the other three categories (Fannie and Freddie future losses, mortgage insurers, and originator put backs) over time.

If Amherst is accurate in its projections - which I expect, given the quality and independence of its research - then Fannie and Freddie have built allowances to cover a mere 21% ($96 billion divided by $448 billion) of the losses they'll ultimately have to absorb from the housing bubble.

It's no wonder the Treasury Department lifted the bailout caps on Christmas Eve; it'll be the only entity willing to plug the GSEs' deepening capital holes.

What does this mean for the markets? It translates into very bad news for complacent stock market bulls and junk bond junkies.

The lifting of the GSE bailout limits strengthens the case for rising Treasury yields in 2010. Rising Treasury yields are bearish for the stock market because higher yields offer better competition for investors' dollars. Rising Treasury rates also increase the cost of capital for all companies.

The elimination of limits on Treasury's capital infusion into Fannie and Freddie is a de facto nationalization. We'll see a gradual transformation of these hollow zombies into new branches of government. They'll implement the official agenda for housing, with little regard for prudent lending standards. This could severely degrade the creditworthiness of US Treasury securities.

The government will probably stick to its dishonest, Enron-style accounting; it won't officially consolidate Fannie and Freddie assets and liabilities onto the federal balance sheet, but many foreign creditors will. These creditors will demand higher rates to compensate for the rising risks of investing in US Treasuries...and that means bond prices will fall...eventually.

Dan Amoss
for The Daily Reckoning Australia

• Fannie and Freddie Say Goodbye to Veto
• The Two Pillars of the U.S. Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?
• Fannie and Freddie: Playing With a Stacked Deck

As the Barron's story pointed out this weekend, both companies are effectively insolvent. But the charade continues. One reality check may come very soon. Fannie Mae has nearly US$120 billion in debt that matures by the end of September. Freddie Mac has US$103 billion in debt.

Can the GSEs roll it over? Who's going to buy it? The Russians? Central banks? Private equity? Anyone. If they can't fund their operations or roll over their debt, what point is there in having a government sponsored mortgage lender that cannot provide liquidity in the secondary mortgage market? (Shudder at what this means for the U.S. housing market...but the phrase 'lower prices' comes to mind.)

Do you get the impression that Hank Paulson doing his best Harry Callahan impersonation? Paulson must have hoped that by publicizing the fact that Treasury COULD buy equity in Fannie Mae & Freddie Mac and recapitalise them, it wouldn't actually have to do it. That the words would have all the power of actions...without any action being taken.

But Harry Callahan had a .44 magnum, the most powerful handgun in the world. And the punk he was chasing down didn't know if Dirty Harry had fired five shorts or six. It was a gamble the punk didn't take because the magnitude of an imprecise calculation would result in a large hole in his head.

The difference here is the market knows that without direct nationalisation, the GSEs won't last the month, and perhaps not the week. Common equity shareholders (those that are left) are headed for the gallows. This particular weapon-"Hey if we really need to we'll buy $25 billion in preferred convertible"-ended up firing blanks.

But what really will they become if Treasury steps in now? We don't know yet. We don't know if it will restore any stability to the housing market. We're pretty sure it won't arrest the fall in U.S. home values. It may even precipitate a blow out in the spreads on GSE debt vs. Treasuries.

About the only thing you can be reasonably certain of is that the direct assumption of Government Sponsored Enterprise liabilities should be a negative for the U.S. dollar. Even if the Feds reorganise the company, liquidate the riskiest assets, and refloat it...there's a lot of uncertainty. Markets don't like that.

On the other hand, there is always the remote possibility that the appearance of a resolution to the decline and fall of the GSEs will give the stock market a shot in the arm. Irrational rallies are frequent when you have a sustained period of low-level crisis. But it all seems to be reaching a crescendo this week, doesn't it?

In the bigger picture, that crescendo sounds like this: debt-financed consumption is not a long-term strategy for economic success. A minor, but building theme, might be this: buying common stock for less than underlying value (intrinsic value, net tangible value, or earnings power) is a sensible investment strategy.

Translation: keep your eyes on the resource prize. The stocks are in for some volatility as the financial markets wait to see which dominoes fall next. But the selling in equity markets simply makes some resource shares a lot more attractive (assuming, as we do, that the trends of urbanisation and industrialisation and rising per capita incomes in the emerging world are not derailed by the collapse of America's Ponzi finance).

One interesting question now is if the Fed's have a fast-enough reaction time to prevent deflation in financial assets from precipitating things like a bank run and a flight to cash. Paulson and Bernanke drew their weapons, hoping they wouldn't have to fire. But now that they do, do they have any policy bullets left? Do they have the political will?

Our guess is that they do. The Fed is becoming a buyer AND a lender of last resort. It will manage the great collateral laundering in the financial markets, exchanging Treasuries for mortgage-backed and other dodgy debt (and expanding its balance sheet as much as it takes to accomplish this, something it has not yet begun to do... "I have not yet begun to defile myself," as Doc Holliday says in Tombstone.)

Meanwhile, there's no need to worry about "pushing on a string." That refers to the inability of Fed policy makers to get money into the system by lowering rates. The futility suggested by that metaphor is based on the presumption that a middle-man, the bank, is necessary to get credit into the hands of people who will abuse it. If the banks won't pass on the Fed's easy credit on to consumers and corporations, then interest rates as a tool for deflating away debts aren't effective.

But the stimulus package from last year showed the government is more than willing to bypass the banks and simply write checks to Americans. Drug dealers always give away free samples to get the user hooked. After that, it's easy.

Mailing checks to Americans is a direct stimulus, although it's hard to hide the nature of the system at that point. That means it can't go on for long until people begin to lose confidence. But even then, public spending can be ramped up indirectly with an increase in the kind of massive public works that FDR pursued in the 1930s.

National rail system? Check! New Manhattan Project for oil shale? Check! A war to rebuild America's infrastructure? Check! The checks are in the mail America!

Our point? The nationalisation of the GSEs may be a kind of starter's pistol which causes the Fed and Treasury to roll out all their inflationary guns...and fire at will.

Dan Denning
The Daily Reckoning Australia

• Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money
• The Two Pillars of the U.S. Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday
• Fannie and Freddie in a Free Market Economy
• How Much it Really Cost to Bailout Fannie Mae and Freddie Mac
• Fannie Mae and Freddie Mac Seized By U.S. Government